Theorie und Politik der Europäischen Integration Prof. Dr. Herbert Brücker Lecture 6 Market Size and Scale Effects Theory and Politics of European Integration

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Last Lecture Preferential Trade Liberalisation ·The PTA Diagram –Free Trade Equilibrium –MFN Tariff Equilbrium –Unilateral Trade Discrimination –Supply Switches –Welfare Effects ·Empiry: Is Trade Diversion an Issue? ·Welfare Effects of a Customs Union ·Customs Union vs. Free Trade Area ·WTO Rules and Customs Union/Free Trade Areas –Art. 24 WTO

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Today's Lecture - Overview Market Size and Scale Effects

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Today's Reading Market Size and Scale Effects ·Baldwin & Wyplosz (2006) “The Economics of European Integration”, McGraw-Hill, Ch 6.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Market Size Matters European leaders always viewed integration as compensating small size of European nations. Implicit assumption: market size good for economic performance. Facts: integration associated with mergers, acquisitions, etc. In Europe and more generally, ‘globalisation.’

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Facts M&A activity is high in EU. much M&A is mergers within one member state about 55% ‘domestic’; remaining 45% split between: ·one is non-EU firm (24%), ·one firm was located in another EU nation (15%), ·counterparty’s nationality was not identified (6%).

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Facts Distribution of M&A quite varied: Big 4: share M&As much lower than share of the EU GDP. I, F, D 36% of the M&As, 59% GDP. ·Except UK. Small members have disproportionate share of M&A.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Facts

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Facts Why M&A mostly within EU? Why UK’s share so large? Non harmonised takeovers rules. ·some members have very restrictive takeover practices, makes M&As very difficult. ·others, UK, very liberal rules. Lack of harmonisation means restructuring effects very impact by member states.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Traditional Trade Theory I: Ricardo Model Explains trade by comparative advantage in production, mainly productivity differences Each country exports goods where it has a comparative advantage in production, i.e. where its relative productivity is below that of trading partner Each country imports goods where it has a comparative disadvantage, i.e. where its relative productivity is below that of trading partner Don’t confuse with absolute advantage! Traditional Trade Theory II: Heckscher-Olin Model Explains trade by differences in relative factor endowments (land, capital labour) Each country exports goods which use relatively abundant factor intensively in production Each country imports goods which use relatively scarce factor intensively in production New Trade Theory: A History of Ideas New Trade Theory: A History of Ideas (I/V)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Empirical knowledge Limited until 1970s, no big data sets available, no computers Boost in empirical research in 1970s Two stylized facts: (i) Net trade pattern supports factor abundance hypothesis (ii) Overwhelming share of world trade is intra-industry trade, i.e. trade in goods of same industries and which use same factors intensively (Grubel/Lloyd 1974) Heckscher-Olin model expects that mainly countries trade which differ in factor endowments Ricardo model expects that technology differences drive trade Actually, the overwhelming share of world trade is between countries which have same factor endowments and apply similar technologies Thus, traditional trade theories cannot explain intra-industy trade New Trade Theory: A History of Ideas New Trade Theory: A History of Ideas (II/V)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Grubel & Lloyd expect that increasing returns to scale are main cause of intra-industry trade Basic idea is simple: If you have increasing returns to scale, it makes sense to locate the production of one variety of a good in one country, which is consumed by the domestic country and the trading partner. Another variety in produced in another country, such that two countries with similar factor endowments and technologies exchange goods if consumer preferences are similar. New Trade Theory: A History of Ideas New Trade Theory: A History of Ideas (III/V)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Development of microeconomic tools: Dixit-Stiglitz and Lancaster explain develop methods to include increasing returns to scale in general equilibrium models in late 1970s Trade theorists demonstrate that increasing returns to scale and/or imperfect competition results necessarily in intra-industry trade in late 1970s and 1980s (Krugman, Brandner, Lancaster, Helpman) These models are called “New Trade Theory”: Idea was long around, but no tools available to demonstrate rigorously Thus, key difference to old theory is that assumption of constant returns to scale and perfect competition is replaces by increasing returns to scale and imperfect competition which enables us to explain intra-industry trade between countries Important for European integration: market size matters! New Trade Theory: A History of Ideas New Trade Theory: A History of Ideas (IV/V)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation New Trade Theory: A History of Ideas New Trade Theory: A History of Ideas (V/V) Main contributions: Paul Krugman, 1979, 1980, 1981 articles. Jim Brander, PhD thesis in late 1970s, 1982, 1984 articles (with Krugman) & strategic trade policies (with Barbara Spencer) in 1980s. Elhanan Helpman, 1981 article and 1985, 1989 books (with Krugman). Further articles on multinational firms in 1980s and 1990s. Jim Markusen, 1980 article and article on multinationals in 1984.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation New Trade Theory: A History of Ideas New Trade theory: Outline of Krugman’s workhorse model Ricardo, Ricardo-Viner & HO models consider differences across countries as cause for trade Krugman model explains trade by geographical concentration of production of varieties of goods trade = produce in one country and sale in another one Internal IRS explain geographical concentration of production Limited resources and imperfect competition explain why different countries produce different variety of a good ·One country cannot produce all varieties (resource constraint) ·Every firm produces only one variety in order to avoid direct competition Every country produces only one variety but buys all varieties, such that we have intra industry trade between similar countries

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation New Trade Theory: A History of Ideas First key element: Increasing returns to scale Internal returns to scale, i.e. average costs of production (AC) fall with increasing production within one firm External returns to scale, i.e. AC of production fall with increasing production of sector (or region), but own AC are assumed to be constant because own contri- bution to total production is small Internal and external returns to scale have different consequences, therefore different models. Here: internal returns to scale.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation New Trade Theory: A History of Ideas Second key element: imperfect competition External increasing returns to scale can be treated in perfect competition framework. Simple but covers only small part of real world phenomenon Internal increasing returns to scale need imperfect competition What implies internal returns to scale: Average costs (AC) > marginal costs (MC) If price (P) equals marginal costs, the firms makes losses: P = MC < AC Thus, we need P > MC to make non-negative profits However, P > MC requires imperfect competition.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation New Trade Theory: A History of Ideas Simple Imperfect Competition Theory Most simple framework: Monopolistic competition or Dixit-Stiglitz framework Each firm is monopolistic supplier of one variety of a good Faces fixed set-up costs, which result in declining average costs if production increases Product demand declines with price, since can substitute this variety of a good by another one Why simple? No strategic interaction between firms. Main elements can be treated as in simple monopoly case. We start with closed economy setting to outline ideas.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Economic logic: Monopoly case (closed economy) Sales Price Marginal Cost Marginal Revenue Curve Demand Curve Sales Price Q’+1 P” Marginal Cost Curve CE D Demand Curve A B Q* Q’ P* P’

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Economic logic: Monopoly case (closed economy) Sales Price Marginal Cost Marginal Revenue Curve Demand Curve Sales Price Q’+1 P” Marginal Cost Curve CE D Demand Curve A B Q* Q’ P* P’ What is the marginal revenue curve? price for first unit – Q times change in price

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Economic logic: Monopoly case (closed economy) Sales Price Marginal Cost Marginal Revenue Curve Demand Curve Sales Price Q’+1 P” Marginal Cost Curve CE D Demand Curve A B Q* Q’ P* P’ Marginal revenue curve is always below average cost curve!

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation MC AC Output, q Price, p Demand Marginal Revenue (MC) p MC q MC Economic logic: Monopoly case (closed economy)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation New Trade Theory: A History of Ideas Monopolistic Competition Monopolistic competition is a market form, where each firm is a monopolistic supplier of one variety of a good, which is a close substitute to another variety, but still different (“imperfect substitutes”) Every firm takes the price of all other firms as given. Its behavior can therefore described as one of a monopolist for the remaining demand Each firm faces fixed set-up costs, which result in declining average costs if production increases What happens if new firms entry market? Residual demand of all other firms always declines Residual demand curve becomes flatter, since the remaining varieties become closer substitutes from the consumer’s perspective Does not hold necessarily for all goods

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Profit-maximizing firms fix prices and production under monopolistic competition such that marginal revenues equal marginal costs, i.e. at point Q*. Note that marginal revenues depend on residual demand curve (RD). Differences between marginal costs and price is called as markup. Sales Price MC MR RD RD’ MR’ Q’ P’ Q* P* The Residual Demand-Marginal Revenue Diagram

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation New Trade Theory: A History of Ideas What happens at market entry of new firms? Market entry shifts Residual Demand (RD) curve downward. Consequently, Marginal Revenue (MR) Curve moves downward and gets flatter. As a result, firms have to reduces markup between prices and marginal costs, i.e. prices and profits fall. Two examples: Duopoly and Oligopoly.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Duopoly case, example of non-equilibrium Residual Demand Curve firm 2 (RD2) Firm 2’s expectation of sales by firm 1, Q 1 Demand Curve (D) MC Residual Marginal Revenue Curve firm 2 (RMR2) x2’x2’ p2’p2’ Firm 2 sales Residual Demand Curve firm 1 (RD1) Firm 1’s expectation of sales by firm 2, Q 2 Demand Curve (D) price MC Residual Marginal Revenue Curve firm 1 (RMR1) x1’x1’ p1’p1’ Firm 1 sales A1A1 A2A2 price

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Duopoly and oligopoly case, equilibrium outcome RD’ D MC x** p** sales A price RMR’ 3x** Oligopoly RD Typical firm’s expectation of the other firm’s sales D MC x* p* sales A price RMR 2x* Duopoly Typical firm’s expectation of other the other firms’ sales

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation In his book, Krugman (1984) uses maths to make these basic points about increasing returns to scale and imperfect competition You can skip the math and just read it for ideas Rely on the previous diagram to motivate why more firms leads to lower prices – this is, after all, a very intuitive outcome (more competition, lower prices). To determines the equilibrium number of firms we introduce two curves: The PP or COMP curve and the CC or Break even curve. The PP-CC or the BE-COMP Diagram

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation BE COMP Krugman’s CC-PP Diagram

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Breakeven-Competition (BE-COMP) Diagram Mark-up (  ) COMP curve BE (break-even) curve ’’ n’  mono  duo n=1 n=2 Numb er of firms

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation CC- or breakeven (BE) curve gives number of firms which breakeven, i.e. make zero or higher profits at given number of firms in market Sales of firm fall with increasing n, such that firms need higher price on product market to breakeven While CC- or BE-curve shows which price is requested to breakeven, the PP or COMP curve presents price maximum at given competition of firms At cut-off point of PP/BE and CC/BE curves, firms request profit- maximizing prices and just breakeven, i.e. price equals average costs (P=AC) Determination of equilibrium number of firms

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Details of COMP curve Marginal cost curve Typical firm’s sales price p" Monopoly mark-up Duopoly mark-up D R-D (duopoly) x mono x duo MR (monopoly) R-MR MC p' A B A’ B’ COMP curve n=1 n=2  mono  duo

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Details of BE curve Sales per firm AC price Total sales CoCo Demand curve Mark-up (i.e., p-MC) oo x o = C o /n o MC euros BE nono p o  o +MC x’= C o /n’ x”= C o /n” A B BA popo AC o =p o n”n’ Home market

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation In the models we have two-way trade between identical countries “Krugman model of trade” (Krugman JIE 1979, AER 1980, JPE 1981) We have only intra-industry trade Domestic countries exports varieties of an industrial good to foreign country and vice versa Two sources of gains from trade: scale effects and pro- competitive effects Implications of monopolistic competition for trade (Krugman’s model)

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Sketch of economic logic liberalisation  de-fragmentation  pro-competitive effect  industrial restructuring (M&A, etc.) RESULT: fewer, bigger, more efficient firms facing more effective competition from each other.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Recall: autarky equilibrium Sales per firm AC price Total sales Demand curve Mark-upeuros x’ BE n’ E’ C’ E’ MC p’ '' AA Home market E’ C

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation No-trade-to-free-trade integration Sales per firm AC price Total sales Demand curve Mark-upeuros x’ BE 2n’ x” n”n’ E’ E” C’C” E’ A 1 E” A MC p” p’ pApA '' AA p” p’ Home market E” E’ C

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Economic logic Integration: no-trade-to-free-trade: BE curve shifts out (to point 1). Defragmentation: PRE typical firm has 100% sales at home, 0% abroad; POST: 50-50, Can’t see in diagram. Pro-competitive effect: equilibrium moves from E’ to A: Firms losing money (below BE). pro-competitive effect = markup falls. short-run price impact p’ to p A.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Economic logic (cont.) Industrial Restructuring: A to E”, number of firms, 2n’ to n”. firms enlarge market shares and output, more efficient firms, AC falls from p’ to p”, mark-up rises, profitability is restored. Result: bigger, fewer, more efficient firms facing more effective competition. Welfare: gain is “C”.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Existence of internal returns to scale is the key to falling prices Each of the n 2 firms sales more than under autarky Therefore, AC are lower than under autarky This implies, they can request (and will request) lower prices to break-even Constraint: zero profits under monopolistic competition imply that prices equal average costs (P=AC). x” p” Firm-level output Why do prices fall under zero profit condition? E”

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation Competition and subsidies Two immediate questions: “As the number of firms falls, isn’t there a tendency for the remaining firms to collude in order to keep prices high?” “Since industrial restructuring can be politically painful, isn’t there a danger that governments will try to keep money-losing firms in business via subsidies and other policies?” The answer to both questions is “Yes”. See Chapter 11, 2 nd Edition.

Prof. Dr. Herbert Brücker Lehrstuhl für Volkswirtschaftslehre, insbesondere Integration Europäischer Arbeitsmärkte Universität Bamberg | | Theory and Politics of European IntegrationLecture 5 Preferential Trade Liberalisation NEXT LECTURE November 27